The stock market has officially entered bear market territory, and the real estate market may not be far behind it. While we don’t recommend knee-jerk selling when the market turns downward, it’s understandable if you want to sell a property that has had a huge price increase over the past few years. The problem is taxes.
It’s likely that you’ll pay at least 15% capital gains tax on the gain and another 25% on the recaptured depreciation. For example, if you bought a rental for $200,000 a few years ago and can sell it for $350,000 now, you’re looking at $25,000 in potential taxes at least, on top of the fees it will take to sell the property.
1031 exchanges could be your best friend. They allow you to sell your property and not pay taxes, as long as you reinvest that money into a new real estate investment. Let’s go over how it works.
1031 exchange steps
- Find an intermediary: You can’t touch the money from the sale of your existing property, or it will wipe out the 1031. You need to find a trustworthy local intermediary who can work through the transaction with you.
- Sell your property: You may want to hold off on actually closing a sale until you’ve at least started a few of the next steps, but selling your existing property is a key part of the transaction.
- Identify replacement targets: Once you sell your existing property, you have 45 days to identify replacement investments, and you must purchase one of those targets. You can invest in multiple new properties, as long as the total purchase exceeds the net sale price of the existing property. The specific targets must be sent in writing to your intermediary by the 45-day deadline. You can identify up to three properties with an unlimited total purchase price, or an unlimited number of properties with a max purchase price of 200% of the sale price of the original property.
- Close on the replacement: You have 180 days from the closing of the original sale to close on a replacement property or properties. Once you close, the net purchase price and net sales price of the two transactions will be compared to ensure that the exchange was done correctly and to calculate the new cost basis of the property for taxes.
1031 exchanges can be stressful, expensive, and complicated. You may be thinking, “What’s the point of selling now if I just have to put the money right back into real estate?”
Remember: You don’t have to invest in another house on the same block. You could use the opportunity to become more geographically diverse. Let’s say you have family living in a different city. You could sell a rental in your market and use the proceeds to purchase a rental near them. That way, you can work out visits to the area to check on your property and family, writing off the travel costs.
You could also invest in a different real estate type altogether. Here are a few of the types of investments that are allowable in a 1031 exchange:
- Multifamily: This is any property that has more than four units and is usually an apartment building or student housing.
- Commercial properties: This could be anything from a hotel to an office building to a self-storage facility. As long as the owner stays the same from property to property, (e.g., if you owned the original property through an LLC, the same LLC owns the new commercial property), there should be a wide variety of commercial options in your area.
- Farmland: This can be a great way to protect your portfolio from inflation — but you may want to hold off unless you already know a good farmer.
- Vacant land: Land banking was a popular concept 30 or so years ago. You buy raw land and hold it until you find a good investment opportunity. If you find land in a good area, it’s likely that the value will increase with inflation. Keep in mind that land banking won’t provide you with cash flow like rental properties will, but buying it could be a good way to keep some dry powder on the sidelines for a while.
Find good help
While you’ll need a good intermediary, you should also invest in a good CPA. A good, detail-oriented CPA will save you money come tax time. That said, it’s possible that you will still owe some taxes, depending on how much debt was on the original property and how much is on the new property, and you’ll need a new calculated cost basis.